Weekend Economist: QE3's final heading

Leading into the June Federal Open Market Committee meeting, we noted that changes to the inflation and unemployment view would be minimal and that the growth outlook would be the focus. We suspected that the 2014 growth forecast would likely be revised down to as low as 2.4 per cent, with the 2015 and 2016 forecasts unchanged. That lower-bound for growth was predicated on the new forecast needing to emphasise that the FOMC remained optimistic on the outlook – necessary to justify a continued reduction in marginal liquidity in the economy post the 1.0 per cent annualised first quarter gross domestic product outcome.

In the event, our expectations were broadly met by the committee. The unemployment rate forecast for end-2014 settled at the bottom of the previous range, now 6.0–6.1 per cent compared to 6.1–6.3 per cent in March. And the committee continue to expect ‘full employment’ to be reached by end-2016 – as measured by the unemployment rate. On inflation, the headline personalised consumption expenditures inflation forecast for 2014 was effectively unchanged. That the 2015–16 PCE annual inflation forecasts continue to be bounded by 2.0 per cent annually indicate an absence of concern over the potential build-up of inflationary pressures.

On growth, the revision to the 2014 forecast was actually a little larger than we had anticipated, with the forecast range revised down to 2.1–2.3 per cent, well below March’s decidedly above-potential 2.8–3.0 per cent. The mid-point of the new forecast range (2.2 per cent) is well below the growth pace seen in 2013 (2.6 per cent) and consistent with our long-held view that growth in 2013 was inflated by abnormal contributions from inventories and net exports which were set to reverse.

Even if we abstract from the impact of inventories and net exports by focusing on domestic demand, it is clear that underlying growth has fallen well short of the FOMC’s earlier expectations. Annualised growth in domestic final demand is currently estimated at 1.6 per cent, unchanged from the average of 2013. And, as we highlighted last week, this estimate will be subject to substantial downward revision come the third estimate, due 25 June.

So as to combat this unfortunate reality, the FOMC again deferred to their forward guidance on the economy. Based on recent partial data, growth is expected to rebound in the second quarter and accelerate in the second half of 2014. In quantitative terms, the 2.2 per cent growth mid-point requires average annualised growth of 3.3 per cent through the remainder of 2014 – twice the average pace seen over the past 18 months. If we do see a material downward revision to the current first quarter estimate on 25 June, then growth over the next three quarters must average 3.6 per cent annualised, last seen a decade ago.

This optimism (and that of the market) is based on ‘signs of improvement’ in the second quarter, namely the non-farm payroll outcomes; growth in industrial production; a rebound in home builder sentiment; and robust ISM readings. Our regular readers will know that we instead prefer to build our US view on key components of GDP (namely actual household and business demand) as well as available labour market detail.

On these metrics, there is little supportive evidence for the growth outcomes expected by the FOMC. While it is true that January retail sales were heavily impacted by the cold, the February 0.9 per cent gain retraced the January move and a subsequent 1.5 per cent gain was seen in March. Since then, both the April and May retail sales outcomes were on the soft side, respectively 0.5 per cent and 0.3 per cent for headline retail. Remember, this is nominal spending.

While only up to April, personal consumption data suggests that services spending growth will be muted in the second quarter: real services spending fell 0.2 per cent in April, compared to the average monthly gain in the first quarter of 0.4 per cent. Growth prospects outside of household demand also seem rather limited. Durables shipments and orders data points to the weak trend in equipment investment persisting into the second quarter. And on structures investment, the highly-volatile construction spending series has been disappointing of late. For residential investment, there is little to be said other than a distinct lack of momentum is apparent.

Of the other, more volatile components of GDP, it is too early to tell what the second quarter will bring. But what can be attested to by the narrative of the past three quarters is that net exports and inventories cannot be relied upon for enduring, above-trend growth. Considering all of these factors, we would argue that we are more likely to see growth near potential (2.2 per cent) for the rest of 2014.

While likely to support headline payrolls jobs growth similar to that seen over the past year (circa 198,000), it is not enough to drive a further acceleration. Hence, we are unlikely to see a notable change in the historically low participation of prime-aged workers anytime soon, nor a marked acceleration in wages. To that end, the structural decay in US labour productivity and real household purchasing power, both associated with the ‘significant’ under-utilisation of workers apparent to the FOMC, is set to persist.

This imbalance between expectations and reality, and cyclical and structural concerns, then frames the looming policy debate. Bar an abrupt, material, unforeseen deterioration in payroll jobs growth, the conclusion of the tapering process is a given. But on the pace and inevitable scale of any Fed funds rate normalisation, there is much-less certainty. This is a point which finds support in the FOMC participants’ June decision to nudge down their ‘longer-run’ median Fed funds rate expectation, from 4.0 per cent to 3.75 per cent.

As evinced by the experience of the housing market through 2013 and into 2014, the US economy remains highly susceptible to changes in term interest rates. And continued low (or no) growth in real household incomes will exaggerate this issue. How term interest rates respond to the initial steps towards normalisation (we believe from late 2015) will dictate how far the Fed funds rate can eventually be raised. Our own expectation is that above-trend growth through 2015–16 will permit it to be raised from 0.50 per cent at end-2015 to around 2.50 per cent by mid-2017; however, this is likely to be the limit of said action, not the FOMC’s 3.75 per cent.

Expectations have allowed for a disappointing reality to be overlooked in favour of a brighter tomorrow. The consequence has been greater pressure on households and less reason for firms to invest in the domestic economy. There are definite limits to this approach which, sooner or later, will be found.

Elliot Clarke is an economist with Westpac.